1. 22-1

2. 22-2 Learning Objectives Compute a target cost when the market determines a product price. 1 Compute a target selling price using cost-plus pricing. 2 Use time-and-material pricing to determine the cost of services provided. 3 Determine a transfer price using the negotiated, cost-based, and market-based approaches. 4 Pricing 22

3. 22-3 The price of a good or service is affected by many factors. Regardless of the factors involved, the price must cover the costs of the good or service as well as earn a reasonable profit. Illustration 22-1 Pricing factors LEARNING OBJECTIVE Compute a target cost when the market determines a product price. 1 LO 1

4. 22-4 The price of a good or service is affected by many factors.   Company must have a good understanding of market forces.   Where products are not easily differentiated from competitor goods, prices are not set by the company, but rather by the laws of supply and demand – such companies are called price takers.   Where products are unique or clearly distinguishable from competitor goods, prices are set by the company. Pricing Goods for External Sales LO 1

5. 22-5 Google The Only Game in Town? Pricing plays a critical role in corporate strategy. For example, almost 50% of tablet computer users say that they use them to read newspapers and magazines. And since Apple’s iPad tablet computer at one time represented 75% of the tablets being sold, Apple felt like it had the newspaper and magazine publishers right where it wanted them. So it decided to charge the publishers a fee of 30% of subscription revenue for subscriptions sold at Apple’s App Store. Publishers were outraged, but it didn’t take long for somebody to come to their rescue. Within 1 day of Apple’s announcement, Google announced that it would only charge a fee of about 10% of subscription revenue for users of its Android system. That might at least partially explain why Sports Illustrated provided an app to run on Android tablets before it provided one for iPads, even though at that time Android tablets only had a small share of the market. Source: Martin Peers, “Apple Risks App-lash on iPad,” Wall Street Journal Online (February 17, 2011). Management Insight LO 1

6. 22-6   Laws of supply and demand significantly affect product price.   To earn a profit, companies must focus on controlling costs.   Requires setting a target cost that will provide the company’s desired profit. Target Costing LO 1

7. 22-7   Target cost: Cost that provides the desired profit when the market determines a product’s price.   If a company can produce its product for the target cost or less, it will meet its profit goal. Target Costing Illustration 22-2 Target cost as related to price and profit LO 1

8. 22-8   First, company should identify its market niche where it wants to compete.   Second, company conducts market research to determine the target price – the price the company believes will place it in the optimal position for the target consumers.   Third, company determines its target cost by setting a desired profit.   Last, company assembles a team to develop a product to meet the company’s goals. Target Costing LO 1

9. 22-9 Wal-Mart Stores, Inc. Wal-Mart Says the Price Is Too High “And the price should be $19 per pair of jeans instead of $23,” said the retailer Wal-Mart Stores, Inc. to jean maker Levi Strauss. What happened to Levi Strauss is what happens to many manufacturers who deal with Wal- Mart. Wal-Mart often sets the price, and the manufacturer has to figure out how to make a profit, given that price. In Levi Strauss’s case, it revamped its distribution and production to serve Wal-Mart and improve its overall record of timely deliveries. Producing a season of new jeans styles, from conception to store shelves, used to take Levi 12 to 15 months. Today, it takes just 10 months for Levi Strauss signature jeans; for regular Levi’s, the time is down to 7 1/2 months. As the chief executive of Levi Strauss noted, “We had to change people and practice. It’s been somewhat of a D-Day invasion approach.” Source: “In Bow to Retailers’ New Clout, Levi Strauss Makes Alterations,” Wall Street Journal (June 17, 2004), p A1. Management Insight LO 1

10. 22-10 The desired profit for this new product line is $1,000,000 x 25% = $250,000 Each cover must result in profit of $250,000 ÷ 200,000 units = $1.25 Market price Desired profit Target cost per unit $20 $1.25 $18.75 per unit Fine Line Phones is considering introducing a fashion cover for its phones. Market research indicates that 200,000 units can be sold if the price is no more than $20. If Fine Line decides to produce the covers, it will need to invest $1,000,000 in new production equipment. Fine Line requires a minimum rate of return of 25% on all investments. Determine the target cost per unit for the cover. - = 1 Target Costing LO 1

11. 22-11 Target cost related to price and profit means that: a.Cost and desired profit must be determined before selling price. b. Cost and selling price must be determined before desired profit. c. Price and desired profit must be determined before costs. d. Costs can be achieved only if the company is at full capacity. Question Target Costing LO 1

12. 22-12   In an environment with little or no competition, a company may have to set its own price.   When a company sets price, the price is normally a function of product cost: cost-plus pricing.   Approach requires establishing a cost base and adding a markup to determine a target selling price. Cost-Plus Pricing LEARNING OBJECTIVE Compute a target selling price using cost- plus pricing. 2 Illustration 22-4 Cost-plus pricing formula LO 2

13. 22-13   In determining the proper markup, a company must consider competitive and market conditions.   Size of the markup (the “plus”) depends on the desired return on investment for the product: ROI = net income ÷ invested assets Cost-Plus Pricing Illustration 22-3 Relation of markup to cost and selling price LO 2

14. 22-14 Illustration: Thinkmore Products, Inc. is in the process of setting a selling price on its new video camera pen. It is a functioning pen that will record up to 2 hours of audio and video. The per unit variable cost estimates for the new video camera pen are as follows. Cost-Plus Pricing Illustration 22-5 Variable cost per unit LO 2

15. 22-15 In addition, Thinkmore has the following fixed costs per unit at a budgeted sales volume of 10,000 units. Cost-Plus Pricing Illustration 22-6 Fixed cost per unit, 10,000 units LO 2

16. 22-16 Markup = 20% ROI of $2,000,000 Expected ROI = $400,000 ÷ 10,000 units = $40 Thinkmore has decided to price its new video camera pen to earn a 20% return on its investment (ROI) of $2,000,000. Cost-Plus Pricing Markup price per unit = Illustration 22-8 Computation of selling price, 10,000 units LO 2

17. 22-17 Use markup on cost to set a selling price:   Compute the markup percentage to achieve a desired ROI of $20 per unit:   Compute the target selling price: Cost-Plus Pricing Illustration 22-9 Computation of markup percentage Illustration 22-10 Computation of selling price—markup approach LO 2

18. 22-18 LIMITATIONS OF COST-PLUS PRICING   Advantage of cost-plus pricing: Easy to compute.   Disadvantages: ► ► Does not consider demand side:   Will the customer pay the price? ► ► Fixed cost per unit changes with change in sales volume:   At lower sales volume, company must charge higher price to meet desired ROI. Cost-Plus Pricing LO 2

19. 22-19 Illustration: If budgeted sales volume for Thinkmore’s Products was 5,000 instead of 10,000, Thinkmore’s variable cost per unit would remain the same. However, the fixed cost per unit would change as follows. Thinkmore's desired 20% ROI now results in a $80 ROI per unit [(20% x $2,000,000) ÷ 5,000]. LIMITATIONS OF COST-PLUS PRICING Illustration 22-11 Fixed cost per unit, 5,000 units LO 2

20. 22-20 Thinkmore computes the selling price at 5,000 units as follows. At 5,000 units, how much would Thinkmore mark up its total unit costs to earn a desired ROI of $80 per unit. LIMITATIONS OF COST-PLUS PRICING Illustration 22-12 Computation of selling price, 5,000 units LO 2

21. 22-21 Alternative pricing approach: Simply add a markup to variable costs.   Avoids the problem of uncertain cost information related to fixed-cost-per-unit computations.   Helpful in pricing special orders or when excess capacity exists. Major disadvantage is that managers may set the price too low and fail to cover fixed costs. Variable-Cost Pricing LO 2

22. 22-22 Cost-plus pricing means that: a.Selling price = variable cost + (markup percentage + variable cost). b. Selling price = cost + (markup percentage X cost). c. Selling price = manufacturing cost + (markup percentage + manufacturing cost). d. Selling price = fixed cost + (markup percentage X fixed cost). Question Cost-Plus Pricing LO 2

23. 22-23 Parker Hannifin At Least it Was Simple For nearly 90 years, Parker Hannifin used the same simple approach to price its industrial parts. It calculated the production cost, then added on a percentage of the cost (about 35%) to arrive at the price. It didn’t matter if a product was a premium product or a standard product. And if Parker reduced its production costs, it then also cut the price for the product. The problem with this approach was that it made it difficult for the company to ever substantially increase its profit margins. So the company’s CEO decided to break with tradition and implement strategic pricing schemes similar to those used by retailers. It determined that for about a third of its products, it had a competitive advantage that would allow it to charge a higher markup. For example, there might be limited competition for the product, or its product might be of higher quality, or it might have the ability to produce a product faster. The company determined that the price increases raised net income by $200 million—not bad considering that net income was $130 million before the price increases. Source: Timothy Aeppel, “Changing the Formula: Seeking Perfect Prices, CEO Tears Up the Rules,” Wall Street Journal Online (March 27, 2007). Management Insight LO 2

24. 22-24 Air Corporation produces air purifiers. The following per unit cost information is available: direct materials $16, direct labor $18, variable manufacturing overhead $11, variable selling and administrative expenses $6. Fixed selling and administrative expenses are $50,000, and fixed manufacturing overhead is $150,000. Using a 45% markup percentage on total per unit cost and assuming 10,000 units, compute the target selling price. 2 Target Selling Price LO 2

25. 22-25 Using a 45% markup percentage on total per unit cost and assuming 10,000 units, compute the target selling price. 2 Target Selling Price LO 2

26. 22-26 Time-and-material pricing is an approach to cost-plus pricing in which the company uses two pricing rates:   One for labor used on a job - includes direct labor time and other employee costs.   One for material - includes cost of direct parts and materials and a material loading charge for related overhead. Widely used in service industries, especially professional firms such as public accounting, law, and engineering. LEARNING OBJECTIVE Use time-and-material pricing to determine the cost of services provided. 3 LO 3

27. 22-27 Illustration: Assume the following data for Lake Holiday Marina, a boat and motor repair shop. Time and Material Pricing Illustration 22-13 Total annual budgeted time and material costs LO 3

28. 22-28   Express as a rate per hour of labor.   Rate includes: ► ► Direct labor cost (includes fringe benefits). ► ► Selling, administrative, and similar overhead costs. ► ► Allowance for desired profit (ROI) per hour.   Labor rate for Lake Holiday Marina for 2017 based on: ► ► 5,000 annual labor hours. ► ► Desired profit margin of $8 per hour of labor. STEP 1: CALCULATE THE LABOR RATE LO 3

29. 22-29 Multiply the rate of $38.20 by the number of labor hours used on any particular job to determine the labor charges for the job. STEP 1: CALCULATE THE LABOR RATE Illustration 22-14 Computation of hourly time-charge rate LO 3

30. 22-30   Material loading charge added to invoice price of materials.   Covers the costs of purchasing, receiving, handling, storing + desired profit margin on materials.   Expressed as a percentage of estimated costs of parts and materials for the year: Estimated purchasing, receiving, handling, storing costs Estimated costs of parts and materials Desired profit margin on materials + STEP 2: CALCULATE THE MATERIAL LOADING CHARGE LO 3

31. 22-31 The marina estimates that the total invoice cost of parts and materials used in 2017 will be $120,000. The marina desires a 20% profit margin on the invoice cost of parts and materials. STEP 2: MATERIAL LOADING CHARGE Illustration 22-15 Computation of material loading charge LO 3

32. 22-32 Labor charges + Material charges + Material loading charge STEP 3: CALCULATE CHARGES FOR A PARTICULAR JOB LO 3

33. 22-33 Lake Holiday Marina prepares a price quotation to estimate the cost to refurbish a used 28-foot pontoon boat. Lake Holiday Marina estimates the job will require 50 hours of labor and $3,600 in parts and materials. STEP 3: CALCULATE CHARGES FOR A PARTICULAR JOB Illustration 22-16 Price quotation for time and material LO 3

34. 22-34 a.$42b. $34c. $32d. $30 Crescent Electrical Repair has decided to price its work on a time-and- material basis. It estimates the following costs for the year related to labor. Technician wages and benefits$100,000 Office employee’s salary/benefits$40,000 Other overhead$80,000 Crescent desires a profit margin of $10 per labor hour and budgets 5,000 hours of repair time for the year. The office employee’s salary, benefits, and other overhead costs should be divided evenly between time charges and material loading charges. Crescent labor charge per hour would be: Question Time and Material Pricing LO 3

35. 22-35 Button Worldwide It Ain’t Like It Used to Be For many decades, professionals in most service industries used some form of hourly based price, regardless of the outcome. But the most recent recession appears to have brought an end to that practice. Many customers are now demanding that bills be tied to actual performance, rather than to the amount of hours worked. For example, communications company Button Worldwide, which used to charge about $15,000 or more per month as its “retainer fee,” now instead charges based on achieving particular outcomes. For example, the company might charge $10,000 if it obtains a desirable public speaking engagement for a company executive. Similarly, a digital marketing agency reduced its hourly fee from $135 to $80, but it gets a bonus if it achieves specified increases in the sales volume on a customer’s website. Source: Simona Covel, “Firms Try Alternative to Hourly Fees,” Wall Street Journal Online (April 2, 2009). Service Company Insight LO 3

36. 22-36 Presented below are data for Harmon Electrical Repair Shop for next year. The desired profit margin per labor hour is $10. The material loading charge is 40% of invoice cost. Harmon estimates that 8,000 labor hours will be worked next year. 3 Time-and-Material Pricing LO 3

37. 22-37 If Harmon repairs a TV that takes 4 hours to repair and uses parts of $50, compute the bill for this job. 3 Time-and-Material Pricing LO 3

38. 22-38 Vertically integrated companies   Grow in either direction of its suppliers or its customers.   Frequently transfer goods to other divisions as well as outside customers. How do you price goods “sold” within the company? LEARNING OBJECTIVE Determine a transfer price using the negotiated, cost-based, and market-based approaches. 4 Illustration 22-17 Transfer pricing example

39. 22-39 Transfer price - price used to record the transfer between two divisions of a company.   Ways to determine a transfer price:   Negotiated transfer prices.   Cost-based transfer prices.   Market-based transfer prices.   Conceptually - a negotiated transfer price is best.   Due to practical considerations, companies often use the other two methods. Transfer Price LO 4

40. 22-40 Illustration: Alberta Company makes rubber soles for work & hiking boots.   Two Divisions: ► ► Sole Division - sells soles externally. ► ► Boot Division - makes leather uppers for hiking boots which are attached to purchased soles.   Division managers compensated on division profitability.   Management now wants Sole Division to provide at least some soles to the Boot Division. Negotiated Transfer Prices LO 4

41. 22-41 Computation of the contribution margin per unit for each division when the Boot Division purchases soles from an outside supplier. “What would be a fair transfer price if the Sole Division sold 10,000 soles to the Boot Division?” Negotiated Transfer Prices Illustration 22-18 Computation of contribution margin for two divisions, when Boot Division purchases soles from an outside supplier LO 4

42. 22-42   If Sole sells to Boot, ► ► payment must at least cover variable cost per unit plus ► ► its lost contribution margin per sole (opportunity cost).   The minimum transfer price acceptable to Sole is: NO EXCESS CAPACITY Negotiated Transfer Prices Illustration 22-19 Minimum transfer price—no excess capacity LO 4

43. 22-43 From the perspective of the Boot Division (the buyer), the most it will pay is what the sole would cost from an outside supplier. Negotiated Transfer Prices Illustration 22-20 Transfer price negotiations—no deal LO 4

44. 22-44   Can produce 80,000 soles, but can sell only 70,000.   Available capacity of 10,000 soles.   Contribution margin of $7 per unit is not lost.   Minimum transfer price acceptable to Sole: EXCESS CAPACITY Negotiated Transfer Prices Illustration 22-21 Minimum transfer price formula—excess capacity LO 4

45. 22-45 Negotiated Transfer Prices In this case, the Boot Division and the Sole Division should negotiate a transfer price within the range of $11 to $17. Illustration 22-22 Transfer pricing negotiations—deal LO 4

46. 22-46 VARIABLE COSTS   In the minimum transfer price formula, variable cost is the variable cost of units sold internally.   May differ - higher or lower - for units sold internally versus those sold externally.   The minimum transfer pricing formula can still be used – just use the internal variable costs. Negotiated Transfer Prices LO 4

47. 22-47   Transfer prices established: ► ► Minimum by selling division. ► ► Maximum by the purchasing division.   Often not used because: ► ► Market price information sometimes not easily obtainable. ► ► Lack of trust between the two divisions. ► ► Different pricing strategies between divisions. SUMMARY Negotiated Transfer Prices LO 4

48. 22-48   Uses costs incurred by the division producing the goods as its foundation.   May be based on variable costs alone or on variable costs plus fixed costs.   Selling division may also add markup.   Can result in improper transfer prices causing: ► ► Loss of profitability for company. ► ► Unfair evaluation of division performance. Cost-Based Transfer Prices LO 4

49. 22-49 Illustration: Alberta Company requires the division to use a transfer price based on the variable cost of the sole. With no excess capacity, the contribution margins per unit for the two divisions are: Cost-based transfer price—10,000 units Cost-Based Transfer Prices Illustration 22-24 Cost-based transfer price—10,000 units LO 4

50. 22-50  Cost-based pricing is bad deal for Sole Division – no profit on transfer of 10,000 soles to Boot Division and loses profit of $70,000 on external sales.  Boot Division is very happy; increases contribution margin by $6 per sole.  If Sole Division has excess capacity, the division reports a zero profit on these 10,000 units and the Boot Division gains $6 per unit. Cost-Based Transfer Prices LO 4

51. 22-51  Overall, the Company is worse off by $60,000.  Does not reflect the division’s true profitability nor provide adequate incentive for the division to control costs. Cost-Based Transfer Prices LO 4 Illustration 22-25 Cost-based transfer price results—no excess capacity

52. 22-52   Based on existing market prices of competing goods.   Often considered best approach because it is objective and generally provides the proper economic incentives.   It is indifferent between selling internally and externally if can charge/pay market price.   Can lead to bad decisions if there is excess capacity.   Why? No opportunity cost.   Where there is not a well-defined market price, companies use cost-based systems. Market-Based Transfer Prices LO 4

53. 22-53 The Plastics Division of Weston Company manufactures plastic molds and then sells them for $70 per unit. Its variable cost is $30 per unit, and its fixed cost per unit is $10. Management would like the Plastics Division to transfer 10,000 of these molds to another division within the company at a price of $40. The Plastics Division is operating at full capacity. What is the minimum transfer price that the Plastics Division should accept? a.$10c. $40 b. $30d. $70 Question Market-Based Transfer Prices LO 4

54. 22-54 Outsourcing - Contracting with an external party to provide a good or service, rather than doing the work internally.   Virtual companies outsource all of their production.   Use incremental analysis to determine if outsourcing is profitable.   As companies increasingly rely on outsourcing, fewer components are transferred internally thereby reducing the need for transfer pricing. Effect of Outsourcing on Transfer Pricing LO 4

55. 22-55 Companies “globalize” their operations   Going global increases transfers between divisions located in different countries.   60% of trade between countries is estimated to be transfers between divisions.   Different tax rates make determining appropriate transfer price more difficult. Transfers Between Divisions in Different Countries LO 4

56. 22-56 Opportunity cost + Variable cost = Minimum transfer price $0 $3.50 $3.50 The clock division of Control Central Corporation manufactures clocks and then sells them to customers for $10 per unit. Its variable cost is $4 per unit, and its fixed cost per unit is $2.50. Management would like the clock division to transfer 8,000 of these clocks to another division within the company at a price of $5. The clock division could avoid $0.50 per clock of variable packaging costs by selling internally. (a) Determine the minimum transfer price, assuming the clock division is not operating at full capacity. 4 Transfer Pricing LO 4

57. 22-57 Opportunity cost + Variable cost = Minimum transfer price $6 $3.50 $9.50 The clock division of Control Central Corporation manufactures clocks and then sells them to customers for $10 per unit. Its variable cost is $4 per unit, and its fixed cost per unit is $2.50. Management would like the clock division to transfer 8,000 of these clocks to another division within the company at a price of $5. The clock division could avoid $0.50 per clock of variable packaging costs by selling internally. (b) Determine the minimum transfer price, assuming the clock division is operating at full capacity. 4 Transfer Pricing LO 4

58. 22-58  Consistent with GAAP: includes both variable and fixed manufacturing costs as product costs  Both variable and fixed selling and administrative costs are excluded from product cost base  Steps in approach: 1. Compute the unit manufacturing cost. 2. Compute the markup percentage – must cover the desired ROI as well as selling/administrative expenses. 3. Set the target selling price Absorption-Cost Pricing LEARNING OBJECTIVE APPENDIX 22A: Determine prices using absorption-cost pricing and variable-cost pricing. 5 LO 5

59. 22-59 Step 1: Compute the unit manufacturing cost. Illustration 22A-2 Absorption-Cost Pricing Illustration 22A-1 Computation of unit manufacturing cost Illustration 22A-2 Other information LO 5

60. 22-60 Solving, we find: MP = ($40 + $38) ÷ $87 = 89.66% Absorption-Cost Pricing Step 2: Compute the markup percentage. Illustration 22A-3 Markup percentage— absorption-cost pricing LO 5

61. 22-61 Because of fixed costs, if more than 10,000 units are sold, the ROI will be greater than 20% and vice versa. Absorption-Cost Pricing Step 3: Set the target selling price. Illustration 22A-4 Computation of target price— absorption-cost pricing LO 5

62. 22-62 Proof of 20% ROI—absorption-cost pricing Absorption-Cost Pricing Illustration 22A-5 LO 5

63. 22-63 Most companies that use cost-plus pricing use either absorption cost or full cost as the basis. Reasons:   Information readily available – cost effective.   Use of only variable costs may result in too low a price – suicidal price cutting.   Most defensible base for justifying prices. Absorption-Cost Pricing LO 5

64. 22-64   Cost base consists of all variable costs associated with a product – manufacturing, selling, administrative.   Since fixed costs are not included in base, markup must provide for fixed costs (manufacturing, selling, administrative) and the target ROI.   Useful for making short-run decisions because variable and fixed cost behaviors are considered separately. Variable-Cost Pricing LO 5

65. 22-65 Steps:   Compute the unit variable cost.   Compute markup percentage.   Set target selling price. Variable-Cost Pricing LO 5

66. 22-66 Step 1: Compute the unit variable cost. Illustration 22A-6 Variable-Cost Pricing LO 5

67. 22-67 Illustration 22A-7 Step 2: Compute the markup percentage. Variable-Cost Pricing LO 5

68. 22-68 Using the $165 target price produces the desired 20% ROI at a volume level of 10,000 units. Illustration 22A-8 Step 3: Set target selling price. Variable-Cost Pricing LO 5

69. 22-69 Proof of 20% ROI—contribution approach Illustration 22A-9 LO 5

70. 22-70 Avoids blurring effects of cost behavior on operating income. Reasons:   More consistent with CVP analysis.   Provides data for pricing special orders by showing incremental cost of accepting one more order.   Avoids arbitrary allocation of common fixed costs to individual product lines. Variable-Cost Pricing LO 5

71. 22-71 Illustration: Alberta’s Boot Division is located in a country with a corporate tax rate of 10%, and the Sole Division is located in a country with a tax rate of 30%. The following illustrates the after-tax contribution margin per unit under transfer prices of $18 and $11. Illustration 22B-1 LEARNING OBJECTIVE APPENDIX 22B: Explain issues involved in transferring goods between divisions in different countries. 6 LO 6

72. 22-72 The after-tax contribution margins differ because more of the contribution margin is attributed to the division in the country with the lower tax rate. Illustration 22B-1 LEARNING OBJECTIVE APPENDIX 8B: Explain issues involved in transferring goods between divisions in different countries. 6 LO 6

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